Microeconomics Level 2 Module 3

1. Microeconomics Level 2 Module 3 Sandeep Kapur

2. Welfare Economics Equity and Efficiency

3. EQUITY How fair is the distribution of goods and services? Of course, fairness is a value judgement In principle, we can distinguish between • Horizontal equity: equal treatment of equals • Vertical equity: different treatment of different people to reduce effects of inequality

4. Equity of Allocations Allocation: a description of who gets what Starting from A, a move to E or F reflects a decrease in equity

5. Efficiency of allocations Relative to initial point A • B is better for all (and C is worse) • D is better for one, and no worse for other B & D are said to be Pareto improvements on A

6. Pareto Efficiency An allocation is Pareto efficient (given tastes, resources and technology) if it is impossible to find another allocation that makes someone better off and nobody worse off. • There can be more than one Pareto efficient allocation, and • even inequitable allocations may be Pareto efficient

7. Are Markets Pareto Efficient? Key Questions • Do free markets always lead to Pareto efficient allocations? • If not, why not? • What are the implications for policy?

8. Competitive Equilibrium & Pareto Efficiency Consider two industries, meals and films. Suppose both are competitive and in equilibrium. Meals cost Pm and films Pf each. • Last meal eaten yields Pm extra utility to consumer; last film watched yielded Pf • Pm and Pf are also the marginal costs of production • This suggests that there is no way to reallocate production to generate a Pareto improvement

9. An Example • SupposePf = 2Pmconsumers need two meals to give up one film • But producers need twice as much resources to 'serve' a film instead of a meal • So they could offer two meals for an extra film, but no net gain for consumers or producers • PUNCH LINE: Competitive equilibrium is Pareto efficient (The Invisible Hand Theorem!)

10. AN IDEA If markets are efficient • confine government intervention to redistribution, and • rely on markets to achieve efficiency However markets may not always be efficient • Market Failure : a circumstance in which equilibrium in free markets fails to achieve an efficient allocation

11. Sources of Market Failure • Tax distortions • Externalities • Public goods • Imperfect information • Imperfect competition We will look at each of these in turn

12. Group Work: Efficiency and Equity… Government intervention in the economy is pervasive. For each type of intervention listed below identify the possible rationale. Is it primarily • (Pareto) efficiency considerations? • a desire for greater equity? • something else? • Income tax • Taxation of petrol • Windfall tax on utilities • Regulating electricity prices

13. …Group Work • Regulating discharge of sewage in the Thames • Legislation against insider trading • Banning the use of cocaine • Unemployment insurance • Making primary school compulsory • Maintaining an army • Running the NHS • Running the Post Office Is there a trade-off between equity and efficiency?

15. MARKET FAILURE: Taxation Suppose we have a tax only on films This tax wedge implies, for last film seen post-tax price exceeds producer's gain consumers’ value exceeds producer's value Implications for meals industry Marginal private cost of meals is below their marginal social cost

16. Taxes distort Consequently, if only films are taxed, • films are too expensive and meals too cheap • we get too many meals relative to social optimum, and too few films IDEA: a tax on meals too, to correct the imbalance

17. THE ‘SECOND BEST’ • If there exists a price distortion, get rid of it to achieve the FIRST BEST (full efficiency) • However, if you cannot get rid of the distortion in one market, it is not always efficient to arrange for other markets to be undistorted • Rather, it helps to spread the inevitable distortion more thinly, by DELIBERATELY introducing new distortions in other markets

18. MARKET FAILURE: Externalities EXTERNALITY • A circumstance in which an individual's production or consumption affects others' utility or productivity • the effect is direct (and not through the market or prices)

19. Externalities: examples • Adverse consumption externality: smoking • Beneficial consumption externality: painting the exterior of your house • Beneficial production externality: bees and orchards • Adverse production externality: pollution

20. Why Externalities Matter THE ESSENTIAL PROBLEM • Market mechanism aligns private costs and benefits • Externalities imply divergence between social and private costs (or social and private benefit) • If divergences exist, should not expect socially efficient allocations

21. Adverse Production Externality For social optimum, wantsocial marginal cost = social marginal benefit At the free market equilibrium E, output Q is higher than social optimum Q*: this results in dead-weight loss EFG SOLUTION 1 (Pigou). Corrective taxation

22. Property Rights Solution 2 (Coase) • Assign property rights and let people trade these rights in ‘pseudo-market’ • Initial assignment affects distribution but gets an efficient outcome • This solution does not work if there are high transactions costs or free riding Efficient quantity is Q*

23. MARKET FAILURE: Public Goods ‘Consumed in same quantity by everyone’ Examples: defence, safe streets, TV signal Characteristics • Non-rival consumption: my consumption does not diminish what is available for you • Non-excludability: impossible or too costly to prevent people from consuming it

24. Why free markets can’t get public goods right • Possible solutions • The problem of free-riding • Note that government needs to ensure right quantity, but does not need to produce it itself

25. MARKET FAILURE: Imperfect information • In reality, information in markets is less than perfect (e.g. we often need to search) • Often there is asymmetry of information between buyers and sellers • Resulting in the problems of adverse selection and moral hazard • This may result in ‘incomplete markets’ or even ‘missing markets’ • Solutions: mitigate informational problems or provide goods directly

26. Moral hazard If you are fully insured against losses, you have little incentive to be careful • insurance company bears the loss, not you • increased carelessness increases risk of loss: this is moral hazard The usual solution Insurance company forces you to bear some risk (excess payments or coinsurance) to maintain incentives to be careful Here you can buy only partial insurance. In some cases, no market at all

27. MARKET FAILURE: Imperfect Competition The essential problem • With market power, price exceeds marginal cost, • so social marginal benefit exceeds social marginal cost, • leading to Pareto inefficiency • Importantly, it is the restriction of output that is costly • First-best solution align price = marginal costs

28. MONOPOLY: benefits • Dynamic efficiency: more R&D? • Better coordination of decisions • Economies of scale: With ‘natural monopolies’, economies of scale so strong that it is cheaper to have one producer rather than duplicate fixed costs. Here, imposing the first-best solution (i.e., price = marginal cost) results in losses

29. MONOPOLY: Solutions Solution 1. Nationalize and finance losses through taxes politically not very feasible Solution 2. Break monopoly e.g. anti-trust legislation in US However, no good for natural monopolies

30. MONOPOLY: Solutions Solution 3. Regulate Prevent abuse of monopoly power through price and non-price controls (UK approach)Practical issues: when is regulation necessary? What form? Solution 4. Nurture competitionEncourage new entrants, (but will they enter and will it only lead to cream skimming?) In general, difficulties with the mix of remedies

31. Group Work: Pollution control You are the National Rivers Regulator, tackling the problem of a chemical firm that is polluting the Thames • If everything could be quantified and valued, show in a diagram how a pollution tax can induce the firm to behave in a socially efficient manner. • Instead of the tax you offer the firm a pollution quota (specifying the maximum pollution it can discharge in any year). Show the size of the quota in the diagram. What difference does it make to the efficient quantity of pollution? • Now suppose information is harder to come by. As the regulator, you are not entirely certain about the firm's cost curve. Does this affect your choice between tax and quotas? • Lastly, suppose there are two chemical firms discharging into the river, one cleaner than the other. Is it better to • set a pollution tax? (same rate per unit polluted for both?) • set each a quota? • auction pollution quotas?

33. INDUSTRIAL POLICY Central idea: market failure calls for an active role for the government Based on the idea that intervention can • Correct failures in markets for knowledge • Assist in the diffusion of new technologies • Correct for excessive risk aversion • Circumvent coordination failures, etc. However, the possibility of government failure

34. Research & Development • PROBLEM: Inventions are a public good, so that unregulated markets may not produce enough • R&D activity equals 2-3% of GDP in OECD • THREE SOLUTIONS • Patents: confer time-bound legal monopoly on the inventor • Procurement: use government research labs e.g. defence • Patronage: provide subsidies to universities

35. New technologies and standards • Problem: uncertainty about new technologies and standards may cause • lock-in in to poor standards (QWERTY?) • delays in adoption (VHS and Betamax) • Solution: guide technological choices?

36. Risk • Problem: Markets may display excessive risk aversion • Collectively, society can pool risks across projects & spread risks across population • Solution: underwrite private sector losses? venture capital?

37. Coordination of economic activity • Location externalities andnew lessons in economic geography • Sunrise industries: correct deficient incentives to acquire skills and imperfection in markets for loans to new firms • Sunset industries: managing the transition: prevent survival of an inefficiently large number of firms

38. Government Failure • However, we must beware of the possibility of government failure. • For instance, the possibility that governments may face the same informational constraints as markets. • If so, government intervention may just replace market failure with government failure

39. Taxation and Public Spending

40. Taxation • Variety of taxes • Direct taxes: income tax, corporation tax • Indirect taxes: on expenditure, VAT

41. Desirable Characteristics of Tax System • Equity • Efficiency • Administrative simplicity • Cost of ensuring compliance • Responsiveness to changing economic circumstances

42. Progressivity of taxation • Proportional: average tax rate constant • Progressive: average tax rate rises with income • Regressive: average tax rate falls with income • We must assess progressiveness carefully: incidence of taxes, benefits, direct provision of goods

43. Tax incidence: who really bears the tax Tax incidence diagrams: either (as here) at consumer prices (supply curve shifts) or at producer prices (demand curve shifts) Relative to original equilibrium, gross price goes up but less than tax (i.e., net price goes down)

44. Tax incidence: who really bears the tax • Regardless of who the tax is levied on, its INCIDENCE depends on elasticity of supply and demand • Inelastic supply/demand means bear the tax • Elastic supply/demand escape the burden

45. Principles of Optimal Taxation • EFFICIENCY • aim to minimise harmful effects on choice • use lump-sum taxes wherever sensible • if choosing variable taxes, choose tax rates to minimise distortion • Ramsey principle: tax rate higher if supply or demand is inelastic • of course, taxes often help correct other distortions: pollution taxes, and ‘sin’ taxes on cigarettes, alcohol

46. Principles of Optimal Taxation EQUITY: Two principles ‘Ability to pay’: take more from the rich ‘Benefits principle’: beneficiaries of public provision to pay more Vertical equity suggests progressive tax system but this may conflict with efficiency

47. Public Spending • Government expenditure: around 40% of GDP • Social insurance: contributory benefits such as unemployment, sickness, pensions benefits • Equity: non-contributory benefits, such as income support, housing benefit, family support • Merit goods: what society believes all should have (externalities or paternalism): benefits-in kind, education, health • Public goods: law and order, defence

48. Public Spending • The big three • Social security • Health • Education • account for 3/5 of all public spending. • We shall study these more carefully

49. Health care

50. Health Care: a merit good? • Sources of muddled thinking • an emotional issue • is health a basic right? But so is food • is health care a commodity like any other? like cars, houses, etc.